# Eli5: Can anyone explain “simple interest rate” vs “effective interest rate”?

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Can anyone explain “simple interest rate” vs “effective interest rate”?
For loans with fixed term e.g. car loans.

In: Economics

Simple: for example, you bullet-lend someone €100 @ 2% interest. Bullet loan means there’s no interim repayment obligation. Your return is €2 in the first year, €2 in the second year, etc.

Effective: same example, but the interest compounds, so in year one your return is €2, but it’s €2*(100%+2%), so €2.04 in year two. In year three it’s €2.04*(100%+2%), etc.

It’s basically the difference between compounded and ‘single’ interest.

First, let’s clarify terminology. The pairs are “simple vs compound,” and “nominal vs effective.” I’ll try to define all four.

* Nominal interest rates are those you see on paper. “This savings account pays 6% interest.” The nominal interest interest rate is the 6%
* Effective interest rates are those you actually end up earning, taking into account how often things are calculated, fees, etc. Imagine you put \$100 in that savings account that earns 6%, and it calculates interest twice a year. After six months, you have \$103. After six more months, you have \$106.09, because in the second half of the year, the 6% nominal rate applied to the \$103. So your effective rate is 6.09%. (This also works with debts, which is how many people miscalculate.)
* Simple interest rates don’t do what I just described in the step above. Instead, you get \$6 at the end of the year to get \$106. However, the following year, your interest is only calculated on the original \$100, so you again only get \$6 in interest earnings. It continues like that every year.
* Compound interest rates DO that thing I said in #3. Interest is calculated on what you invest AND on any interest you’ve earned thus far. This is how over time your earnings can grow very large, though most of the gains are in later years. That’s why it’s important to invest very early and let time work its magic.

Hope that helps.